Tuesday, 31 March 2009

(Ir)rational protectionism

Paul Mason points out that world trade (more precisely exports from the developed world) is down by 40% on an annualised basis.

We can imagine rational reasons for people to trade less with each other - for example an increased desire for saving reduces the resources available to devote to the slightly risky activity of exchanging with distant parties. But what appears at first sight not to be rational is the distinction between local and foreign trade.

Trade within the UK, for example, is certainly not down by 40%. Of course the idea of "trade" within a country is not a very well-defined concept - one could perhaps look at interstate trade in the US, but I assume that such data is not collected comprehensively. But if we generalise to the idea of economic exchange in general, then GDP is essentially the measure we are looking for. And GDP, of course, has not fallen by 40% or anywhere close.

So why has international trade fallen so much more? There are several proximate reasons, and then some deeper underlying causes. The proximate reasons are rational, while the underlying ones appear not to be. But we will see that there is still some logic to them after all. The immediate causes include:
  • Flexible supply chains - allowing orders to be quickly reduced or cancelled
  • Unavailability of export credits
  • Increased risk of currency movements
All of these are straightforward business drivers which could rationally lead someone to decide either to import or export less. But each of them is in turn caused by some underlying behaviour which is arguably less rational. In particular, why would these apply to foreign relationships but not domestic ones?
  • Supply chains are flexible because buyers are unwilling to tie themselves into long-term supply contracts with foreign parties. Partly this comes from a lack of faith in being able to enforce contracts via foreign legal systems; partly from a feeling that there is less shared understanding of expectations between the two parties. There's also an effect from the relative youth of many such relationships - international trade has grown so fast recently that many supply relationships are still quite new, and therefore more tentative than local ones.
  • Export credits are less available because of a general reduction in credit availability, but also because of a fear by lenders of international economic instability. The underwriters of such credit are likely to know less about the details of the economic situation in other countries than a bank's standard credit committee will know about the local economy. There's also an effect from the length of credit terms. Local trade finance is likely to extend for 45-60 days. International trade has built-in delays, so export credits may have to finance a 90-180 day period or even longer. But this is not really a distinction between local and international trade - it is a distinction in physical distance and type of project. If the project is to build a plasticine factory or ship 10,000 tons of coal 4,000 miles, it doesn't make much difference if your customer is on the other coast of the US, or the same distance away in Brazil.
  • Foreign currency transactions are riskier than local transactions mainly because local ones benefit from sticky prices (or wages). In theory, the closure of a big factory in Detroit might lead to a collapse in the local economy, with corresponding falls in wages and prices. This would have exactly the same effects as a devaluation of the ringgit. But in reality, wages and prices would not fall very much, meaning that trade with Michigan (assuming you're in the US) is more stable than trade with Malaysia.
A few of these underlying reasons are perfectly rational, but many appear not to be. The drivers which are not in conformance with a traditionally efficient economic market include:
  • A lack of trust which differentiates between foreign and local people
  • Information barriers which are higher for foreign companies
  • High transaction costs of dealing with foreign legal systems
  • Sticky wages and prices which act differently to foreign currencies
I'm avoiding careless use of the word "irrational" here because it's a lazy way of avoiding a proper analysis. People do things for a reason, and if those reasons are not accounted for by traditional economic theory, we need to acknowledge that as a flaw in the theory, not a flaw in the people.

So what might be at the root of these apparent irrationalities?
  • Language differences create a barrier to communication and learning. There is a cost and time to absorbing information about other people, and language increases that cost.
  • People use heuristics to evaluate other people. This capability evolved to reduce the time and risk involved in trying to individually get to know every new person you met; and to overcome the inherent information barrier of not being able to read the other person's mind. But it has the dangerous effect of leading us into false assumptions about the similarity between us and people who look or speak like us.
  • There are game-theoretic reasons why foreign legal systems do not necessarily correspond with ours. This effect is mitigated now in the EU (and much earlier in the US, as interstate trade was established and deepened in the 19th century) but across other boundaries the differences are greater. Simply put, local companies do not necessarily want foreign ones to have the same protection that they do; voters don't want to change their systems or make themselves subject to someone else's rules; and even though it might be in everyone's long-term interests to make the systems compatible, the selfish incentives act like a prisoner's dilemma in retaining the differences.
  • Sticky wages and prices are the biggest one, and are caused largely by the money illusion (see this link for an explanation). If Joe's salary is cut by 10% but all prices were also cut by 10%, he wouldn't be any worse off (debts and savings would be affected but these will net out on average). But he'd probably feel that he'd been ripped off. This is a well-known and easily demonstrable psychological effect. But if his currency falls in value by 10% against all other currencies, which is exactly the same thing, he barely notices. Part of this effect comes from long-term contracts which fix prices for different reasons (though those in theory could allow for adjustments to match the general price level), but most of it is a psychological desire for apparent stability and predictability, and a cognitive resistance to the need to recalculate habitually familiar transactions.
The more we understand about these behavioural traits - which are not necessarily irrational, but are not taken into account in classical economic models - the more we'll understand and be able to combat protectionism.

Indeed this discussion has not really touched on protectionism as such, which is the erection by governments of artificial barriers to trade. But with all these psychologically natural reasons not to trade internationally, who needs artificial ones? The world trade agenda needs to give as much time to these issues as it does to the dismantling of explicit legal barriers.


Update: This also has implications for developing economies and what export industries they choose to specialise in. Stephanie Flanders points out that Canada is very well-prepared for a recession, partly because of the stability of the industries that dominate their economy. Raw materials, substantial trade with the US and no major focus on innovative or consumer-driven industries.

But then, Canada has had hundreds of years to prepare for this. A long-term, slow investment in developing industries like mining and timber does lead to a strong position. But developing economies that want to build an export position quickly will naturally choose industries with potential for faster growth (and consequently faster shrinkage in times like this).

A country which wants to build a strong and defensible export position would do well to look at the above psychological factors when choosing its export markets and the industries it invests in. Deep integration with another, richer, economy - achieved by overcoming these intrinsic barriers - provides lots of inertia and a strong position when economic turmoil arrives.

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